Bleed Or Blowup

Abstract: This paper surveys the behavioral literature in search of possible explanations for the preference for negative skewness on the part of economic agents. 1) We relate the mathematical properties of skewness to biases in inductive inference and suggest further research needed for the conditions of the real world in which agents are not presented the probabilities of rare events but need to derive them themselves. 2) We link the acceptance of the occasional large loss for a steady small profit (as opposed to the opposite payoff) to elements of prospect theory and the research on well-being and the hedonic treadmill effects.

You can see why people tend to go for these streams of returns by considering one of their properties:

Property 1: Camouflage of the mean and variance. The true mean of the payoff is different from the median, in proportion to the skewness of the bet. A typical return will, say, be higher than the expected return. It is consequently easier for the observer of the process to be fooled by the true mean particularly if he observes the returns without a clear idea about the nature of the underlying (probability) generator. But things are worse for the variance as most of the time it we be lower than the true one (intuitively if a shock happens 1% of the time then the observed variance over a time window will decrease between realizations then sharply jump after the shock).

So such opportunities look like easy money - good return, and low risk. Until, after 15 years, you blow up and lose everything.

I think Behavioral Econ is a particularly rich vein for economics today - studying, cataloguing, and finding explanations for widespread irrational behavior. Traditional econ has done a fabulous job at analyzing rational behavior, which is a great first start on modelling human behavior, but is incomplete.

So, the question this raises, as far as I am concerned, is, "how do we make a buck by either (best) selling rationality to people, or (second best) aligning our interests with their irrationality and collecting the rents?"

The second-best solution would seem to be some sort of inverted gambling game. Note that most gambling, at least at the micro level, has the opposite profile -- continuous losses, occasional drastic gains. One bleeds dozens of small bets into a poker pot in order to collect a large pot occasionally. Would it be possible to create a gambling game with the opposite property and, if so, would it (as the theory seems to predict) be compelling? Gambling "systems" tend to reverse the profile, allowing small gains continuously until they ruin you, but are generally profoundly dull to play.

The best solution -- identifying irrationality and selling rationality where you can find it -- seems to me underexplored. Education does a piss-poor job of delivering rationality. Perhaps some sort of automated risk-management software built straight into a credit card would be a better bet. A sort of financial calorie-counter. There's an interesting technological and sociological problem built into all this economics. Of course, the other alternative would be to take the second-best option, somehow securitise it, and sell people shares in the rents on their own irrationalities.